By Edward R. Jenkins Jr., CPA
The National Starch transaction model received some prominent press coverage recently, because this is the structure being used in the pending News Corp. acquisition of Dow Jones & Co. The National Starch structure can be used when a target acquisition has both a minority ownership group of shareholders that exercises control and desires a tax-free treatment of the transaction, and a larger group of shareholders comfortable with a transaction for cash, which is taxable. More common tax-free transactions detailed in Internal Revenue Code (IRC) §368 don’t work in this kind of scenario because an insufficient continuity of interest - arising from the minority, yet controlling shareholder group - precludes the use of more traditional tax-free reorganizations. The minority group may be influenced by estate planning considerations; particularly the potential to avoid income tax on the stock gain and to receive a step-up in basis via IRC §1014 as the low-basis stock transfers through an estate.
National Starch Transaction Structure
The structure of a National Starch transaction works as follows:1 The acquirer company contributes cash to a "Newco" in exchange for all of its common stock. Stockholders in the target company who desire tax-free treatment contribute their stock to the Newco in exchange for preferred stock or a different class of common stock. The Newco then acquires the remaining shares of the target for cash, or uses a merger subsidiary to complete the acquisition.
The legal underpinning of the transaction is an IRC §351 contribution of property for stock in a transferor-controlled corporation. Acquisitive use of IRC §351 is now generally common in circumstances where IRC §368 reorganizations are not desirable or feasible.
Why the Name National Starch?
The term National Starch transaction arises from the 1978 acquisition of National Starch and Chemical Company by Unilever.2 Two elderly shareholders, who together owned 14 percent of National Starch, effectively controlled the company. The two wanted to avoid income taxation on the gain and to use IRC §1014 to receive a step-up in basis for their shares when the shares passed through their respective estates.
The IRS approved the transaction in a private letter ruling, then reversed its position in Revenue Ruling 80-284, then reversed itself again four years later in Revenue Ruling 84-71, indicating that IRC §351 worked in those circumstances. IRC §351 was revised by the IRS Restructuring and Reform Act of 1998 to restrict the use of non-qualified preferred stock. Those restrictions and exceptions are part of the reason why this kind of acquisition agreement must be careful to meet those exceptions to avoid taxable treatment under IRC §351(b).
Use by News Corp.
The Form 8-K filed by News Corp. on Aug. 1, 2007, details the Dow Jones acquisition. Groups A and B of Dow Jones & Co. shareholders can receive either $60 cash per share or Class B units of Newco. Group B, which will receive Class B units of Newco, is limited to no more than 250 shareholders and no more than 10 percent in the aggregate of the outstanding shares of Dow Jones & Co. The number of units received in the exchange by Group B will be determined by dividing $60 by the weighted average closing price of News Corp.’s Class A common shares over the five trading days immediately preceding the close of the transaction. The limitations on the number of shareholders and percentage of units exchanged are intended to make sure the transaction meets the requirements and exceptions under IRC §351.
The transaction is subject to customary closing conditions and shareholder approval as of this writing. Tax counsel is to issue a tax opinion regarding the qualification of the shares contributed as an IRC §351 transaction and that the Class B units issued from Newco are not non-qualified preferred stock within the meaning of IRC §351(g).
Further Uses
The reconciliation of the divergent interests of two groups of shareholders - as in the Unilever-National Starch or the News Corp.-Dow Jones transactions - is a great use of this structure permitted under IRC §351. Other situations may be able to make use of the §351 structure. For example, circumstances may exist where a minority ownership group effectively controls the board of directors. IRC §351 can accomplish tax-free transactions for the minority group when there is insufficient continuity of interest to use the reorganization provisions of IRC §368. Another possible use of the structure could be in management buy-outs of companies. When a corporation is available for sale, and its management would like to buy out the former minority ownership while preserving some of the former minority holders’ tax attributes, a variant of the National Starch structure may work. Additionally, the non-management equity contributors for a management buy-out may want to consider a variant of the National Starch structure for the exit strategy when the time comes for the non-management equity investors to exit.
1 Ginsburg & Levin, Mergers, Acquisitions and Buyouts, Volume 2, Aspen Publishers, January 2007, p. 9-37.
2 BNA Tax and Accounting Center, Portfolio 770 3rd, http://taxandaccounting.bna.com.
Edward R. Jenkins Jr., CPA, is managing member of Jenkins & Co. LLC in Spring Grove. He is also a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at edwardj@wemanagetaxes.com.
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